Crisis Unveils Fragile Foundations
February 27, 2007
By Vladimir Pillonca | London
Italy’s sudden government crisis looks likely to be followed by a similarly swift comeback. Prodi is expected to retain his mandate, via a crucial confidence vote in the Upper House on Thursday. However, the margin of victory is likely to be tight, and it will rely on the vote of several lifetime senators. The situation remains volatile, and the longer-term sustainability of such a tight majority is open to debate. Further setbacks appear a concrete possibility.
Conclusions The most important lesson from this crisis is that, in the absence of electoral reform, political instability is likely to remain endemic. The crisis exposed the inherent fragility of the current coalition-based set-up, and the inadequacy of the current electoral system. Political turbulence may subside — at least initially. But after an initial honeymoon period, inter-coalition squabbles are likely to surface again. If anything, risks are that squabbles may start straight away, starting with the forthcoming debate on pension reforms. Investment implications and risks A quick resolution remains desirable for investors, but political stability over the medium term is far more important, in our view. While a swift resolution seems close, the durability of Prodi’s coalition remains uncertain, and it could prove fragile. So far, the reaction of financial markets has been muted, perhaps partly because a quick resolution is widely expected. But if a drawn-out scenario of uncertainty were to develop, a prolonged bout of financial market volatility could follow. Under this scenario, Italian assets could under-perform, and bond spreads could widen as risk premia rise. Three scenarios We explore three alternative scenarios. Scenario #1 seems the most likely first course of action right now to us: Prodi stays on with a slightly larger majority. In scenario # 2, Prodi’s government does not last for long and an interim broad-based government is formed (under a new leader). The primary aim of this broad-based government would be to reform the electoral system. In our final scenario, elections are called, under the current electoral system. Scenario #1: Prodi stays on, but with some tricky hurdles to negotiate… The first scenario currently seems the single most likely outcome: Prodi remains in charge, with a relatively tight majority at the upper house. How lasting and stable such an arrangement might prove depends on how many centre-right defectors Prodi can gather (one so far) and how reliable the votes from the two far left senators (who defected last week) might prove. Prodi’s centre-left coalition appears to have found only a sketchy accord on 12 (very) broad points over the weekend, ahead of Thursday’s confidence vote. Wednesday’s speech to the Upper House will help to clarify the agenda. So far, agreement on these points has not been unanimous, and voting margins are likely to be fairly tight. Prodi’s centre-left coalition should command around 158 votes (including last week’s two defectors) plus those of most of the seven lifetime senators. This should help to secure Prodi’s survival by a few votes (at least 161 votes are necessary). The opposition should muster around 157 votes in total. By most standards, these are tight margins. Looking ahead, Prodi’s coalition remains exposed to the demands of small but critical components, notably the far left, which triggered the government’s crisis last week. While the far left has clearly condemned the defection of Senator Turigliatto, who helped to trigger the crisis, and promised support, the durability of this commitment remains to be seen. With the controversial and politically charged debate on pensions looming, the legislature would start with a challenging hurdle. Besides, trade unions are already stepping up the opposition to any significant changes to the fiscally unsustainable profligate pension system. One the bright side, assuming the continuity scenario, the reform effort could continue. Capable technicians such as Padoa-Schioppa, Visco and Bersani could step up the reform effort. Padoa-Schioppa has remarked that the reform effort will go forth. Provided the reform effort is not hindered too much by internal squabbles, the economy could continue to strengthen, and Italy’s fiscal position could steadily improve. In this reformist environment, the corporate outlook would get better, as would potential growth. This optimistic version of our first scenario requires a decent working majority — far from a foregone conclusion at this point. Should the reform process stall, the medium-term implications for the economy could be significant. While the first instalment of the Bersani liberalisation programme became effective in August, a more recent set of related initiatives need to be approved by the end of March to become effective. More liberalisation in the making was one of the reasons why were expecting Italian CPI inflation to remain below the 2% mark this year and into most of next year. An interruption of the liberalisation and reform processes would bias the path of our inflation forecasts upwards. In addition, depending on which scenario materialises, economic growth next year may also be slower. Scenario # 2: An interim broad-based government, and electoral system reform. This is unlikely to happen right away, but if Prodi’s government should falter, this may be the most viable way forward. Under this scenario, a broad government coalition is formed under a new leadership, perhaps from a super-parties institutional background (i.e., this would be a so-called technical government). The main objective would be to reform the electoral system. Ideally, the new electoral system would feature a stronger non-proportional representation in the upper house, so that coalitions with a small majority have enough votes to govern the country. After this potentially drawn out process, elections could take place. This solution may not appear ideal, given the prolonged transition period before a new election, but it has a fundamental advantage: the potential to resolve a situation whereby a new election results, once again, in a narrow majority with a consequent slowdown of the legislative process. The tight electoral outcome of recent years suggests this risk is real. There are some obvious considerations. First, the approval of this reform would be tricky to negotiate, given the high number of small parties whose vote would be needed for approval in the first place (a clear conflict of interest). Second, uncertainty would likely rise significantly until a new electoral rule is approved (assuming it is a sensible solution). But a more effective and pragmatic electoral system would ultimately result in a more stable government, helping to foster a less uncertain environment. Under this scenario, the BTP-Bund bond spreads could widen until a clear outcome with a sufficient majority. Scenario # 3: Election times (not) again! Under the third and final scenario, a broad-based collation does not work out, so President Napolitano dissolves Parliament and calls for new elections. New elections might end up favouring a shift of voters towards the centre right. This is quite plausible, given that the centre left coalition just passed a tough Budget, and fiscal pressure rose across the economy. Even the recent positive economic developments might have done little to dispel those memories. But on the whole, new elections will present a new challenge. It would be a tall order to replace the previous group in charge of economics and finance under Prodi’s leadership. Worse still, we could once again witness a close margin between majority and opposition, especially in the upper house. The biggest risk is that elections without a valid electoral reform may not be such an effective solution at all.
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Overheating Signs – Reminiscent of 1993-96 Cycle
February 27, 2007
By Chetan Ahya (Mumbai)
Overheating raises concerns on sustainability of current growth trend
Policy makers continue to be worried about overheating as a number of macro indicators are flashing red. First, inflation pressures have continued to mount. The three-month moving average CPI inflation for industrial workers increased to 6.7% as of December 2006 (last data point available), compared with an average of 4% in 2005. Second, the current account deficit widened to US$6.9 billion (3.3% of GDP, annualized) during quarter ended (QE) Sept-06, driven by an all-time high trade deficit. Third, over the last two-and-a-half years, there has been a widespread 100-300% rise in property prices across the major cities in the country. Fourth, the banking sector balance sheet is stretched and reflects the constraints of maintaining current levels of demand growth. Although credit growth has moderated to 30% from the peak of 33%, it remains significantly higher than the deposit growth rate of 23%. Repeat of the 1993-96 cycle?
The current macro environment reminds us of a similar overheating that the Indian economy witnessed during the 1993-96 growth acceleration cycle. However, the 1993-96 cycle was a smaller cycle in terms of duration and scale due to lower levels of foreign capital inflows as a percentage of GDP. We detail below some of the comparative points of the 1993-96 cycle: Global macro environment: The global macro backdrop currently appears to be similar to that in the mid-1990s. Back then as well, the US fed funds rate fell sharply and capital flows to emerging markets had picked up significantly. Balance of payments trend: The sharp rise in capital inflows pushed India’s balance of payments surplus to 4.1% of GDP by Sept-94 from the low of 0.2% in Sept-93. This increase in balance of payment surplus in turn supported an expansionary monetary policy. Short-term rates (91-day T-bill) declined from 11% in March 1993 to a low of 7.3% in April 1994, pushing real rates into the negative range. Credit cycle: Credit growth accelerated to an average of 25% in F1996 from the low of 12.4% in F1994. Credit-funded spending supported a sharp recovery in domestic demand and corporate profit growth. Growth trend: GDP growth accelerated from an average of 4.1% during the three-year period F1992-F1994 to an average of 7.5% during F1995-F1997. Industrial production growth accelerated from an average of 3% during the three-year period F1992-F1994 to an average of 9.6% during F1995-F1997. Corporate profitability: During the 1993-96 cycle, corporate sector profits as a percentage of GDP had more than doubled. This was reflected in savings and investment ratios, supporting the argument that the accelerated growth was sustainable for longer. Note that the savings to GDP ratio had increased to 25.7% in F1996 from 22.2% in F1993 – with the corporate sector contributing two-thirds of the increase. Investment to GDP had increased to 28.5% in F1996 from 25.0% in F1993. However, a concurrent emergence of overheating signs had caused a concern among policy makers: (a) The inflation rate accelerated to double-digit range in 1994 and 1995 from an average of 6.3% in 1993. (b) The trade and current account deficit had widened but, due to relatively low levels of trade integration, excess demand was reflected more in inflation. (c) Property prices had moved up in sharply in major cities. However, the depth of the property euphoria was less than the current cycle due to lower penetration of financial services and lower levels of urbanization. These overheating concerns did influence the RBI’s policy at that time. Even as the sharp reduction in balance of payment surplus caused tightening in liquidity, the RBI hiked the CRR by 1% to 15% in mid-1994 in reaction to the rise in inflation to double-digit levels. In its 1994-1995 Annual Report, the central bank expressed its policy stance that “monetary policy for 1994-1995 was framed against the backdrop of a high inflation rate, fuelled by the high expansion of primary liquidity attributable largely to capital flows”. The 91-day T-bill rate moved up to 11.9% by April 1995 from the bottom of 7.3% in April 1994. The further slowdown in capital inflows ensured that the tight liquidity environment prevailed through mid-1996, resulting in a sharp contraction in the growth trend, with industrial production decelerating to 3.9% in September 1996 from the peak of 14.4% in February 1996. (The Asian crisis in 1997 only exacerbated the growth slowdown trend, resulting in major risk aversion in the corporate sector.) Risk of similar downshift of growth trend in current cycle
Like the early 1990s cycle, strong inflows of global risk capital have again created a great opportunity for India to lift its sustainable growth rate to much higher levels. Unusually low global interest rates and large capital inflows into India (and emerging markets in general) have allowed an expansionary monetary policy. In the current cycle, the capital inflows have been even larger, resulting in a much higher growth push. Cumulative capital inflows in the last three years have been 3.6% of GDP, compared with 2.3% during the 1993-1996 cycle. Credit outstanding has increased by US$250 billion to US$450 billion over the last three-and-a-half years. Initially, credit-funded spending was driving growth without causing any excesses as the domestic productive capacity was under-utilized. However, we believe that over the last 12-18 months, signs of overheating have become more evident. A hesitant and late investment cycle has resulted in less than optimal utilization of the opportunity. Overheating concern is forcing policymakers to check the growth acceleration. Blame it on the weak supply response
For an emerging economy like India with a rising working population and large unemployed work force, limitations to potential growth are determined by the pace of reform to the economic environment, which allows resources to operate productively. Although the government has been initiating reforms, the pace of implementation is not strong enough to sustain the current 9%. Unlike China, India’s response for productive capacity creation has tended to be weak, i.e., growth in productive capacity has been relatively slower than demand growth. This has resulted in India’s absorption of liquidity for productive capacity being less than optimal. The skewed trend is due to the unsatisfactory performance of the public sector. We believe that a commensurate rise in the supply side is critical to ensure a sustained acceleration in growth to 9%. The government needs to implement measures to accelerate the supply-side response by investing in infrastructure, implementing labor reforms, improving the management of government finances and strengthening the administrative framework. But isn’t the supply response finally coming through?
The key challenge in determining policy response to the concerns on potential overheating is the extent of the lag in supply-side changes. Although later than warranted, clearly the investment cycle is picking up and therefore in the strictest sense a large part of the supply constraints will be transient in nature. However, the effective supply creation could take some time and, in the intermittent period, macro stability risks could be exacerbated. This lag will be particularly high in areas where government participation is required. Not surprisingly, in December 2006, when the RBI hiked the cash reserve ratio, it indicated “that expansion of capacity is underway but the realization could be could be constrained over the next two years”. Considering this lag, the RBI is forced to tighten right at the time when capex is picking up. Global Environment will have important role in final outcome
Even in 1993-96, although the RBI did initiate tightening measures with signs of overheating, we believe that the effective moderation in aggregate demand growth was driven by a slowdown in capital inflows. We believe that in the current cycle too, while the RBI is pressing the brake pedal, increased global integration of the financial markets has made the monetary policy measures less effective. Currently, the global environment appears to be mildly supportive of the RBI’s tightening effort. In our view, recent aggressive measures by the RBI to increase the short-term cost of capital have been successful in forcing banks to initiate sharp hikes in lending rates. For instance, the largest private sector bank has increased its mortgage lending rate by about 300bp over the last 12 months to 11%, taking it to a four-and-a-half-year high. We believe that this will cause a soft landing of the growth cycle. However, we believe that the scale and duration of the slowdown will be influenced by the global environment. Upside risks
We have a varying view among our global team members on the likelihood of continued excitement for risky assets. If continued global risk appetite for EM assets were to ensure higher capital inflows into India, liquidity conditions could improve, supporting the current high growth rates for a while longer. However, such an outcome would increase the risk of macro indicators such as inflation, the current account deficit and asset prices worsening to precarious levels in the intervening period
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Rates Kept Steady at 3.5%
February 27, 2007
By Deyi Tan | Singapore
BNM maintains status quo: The central bank (BNM) kept the overnight policy rate unchanged at 3.5% today for the seventh consecutive month. This is in line with our and market expectations. Growth moderates; inflation remains benign. The credit growth decelerated to more than a two-year low of 6.3% YoY in December (versus 7.3% YoY in November). In addition, the credit-funded consumption growth continued to weaken in line with the moderating credit growth. The passenger car and commercial vehicles sales contracted further to 23.6% YoY and 26.6% YoY in December (versus -8.4% YoY and -2.6% YoY in November). However, inflation remained subdued, rising by 3.1% YoY in December (versus 3.0% YoY in November). This brings the full-year inflation number to 3.6% YoY (versus +3.1% YoY in 2005). Central bank likely to keep rates unchanged. In its monetary policy statement, the central bank stated that “the outlook on inflation is relatively benign with average inflation expected to be significantly lower than in 2006”. In addition the BNM remained optimistic on growth front — “the Malaysian economy is expected to experience sustained growth, with stronger growth estimated for the second half of the year”. We expect growth to remain moderate and inflation to remain benign for the rest of 2007. We believe that the central bank will likely maintain rates at the current level for the rest of the year.
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